Chapter 8 Tax Impacts on Wealth Accumulation and Transfers of the Rich Wojciech Kopczuk and ...

55 Pages·2002·0.18 MB·English

Chapter 8

Tax Impacts on Wealth Accumulation and Transfers of the Rich

Wojciech Kopczuk and Joel Slemrod

After many years off the political radar screen, the U.S. estate and gift tax system
has recently received a lot of attention, culminating in the scheduled repeal of the tax in
2010 contained in the 2001 tax legislation. Opponents of this tax routinely deride it as
unfair and point to its deleterious effects on wealth accumulation and its impetus to tax
avoidance. Supporters tend to diminish these effects but at the same time often emphasize
its large effects on other aspects of behavior, in particular charitable giving. Thus, the
policy debates often make strange bedfellows with regard to behavioral responses –
taking seriously some margins of response but minimizing others. These positions are
not necessarily inconsistent, as it is certainly logically possible that some margins are
more responsive than others. However, it would be of interest to assess the behavioral
responses on a consistent basis. After all, the place of an estate tax within the overall tax
system does depend, inter alia, on how it affects behavior.
Unlike some other contexts, however, quantifying these behavioral responses is
not simply a matter of estimating the relevant elasticities within a well-accepted model of
choice under constraint. On the contrary, macroeconomists are engaged in an ongoing
and fierce debate about the very motivation for bequests, and the underlying model of
behavior. Moreover, estate planning usually occurs in the context of a family and
depends on the preferences of both spouses and their relationship. As a result, looking at
estate tax returns may shed some light on the appropriate model of family decision-
making. We investigate spousal bequest decisions and use of a particular kind of trust
(QTIPs) with this issue in mind. Finally, estate tax planning represents forward looking
behavior in its most extreme form, as it pertains to what will happen after an individual's
death and requires contemplating one's own death. Analysis of estate arrangements and
their responsiveness to changes in tax policy might provide new evidence about the
importance of various behavioral considerations as opposed to the "rational" and
dynamically consistent standard model of behavior.
In this paper we review and extend what is known about the effect of estate taxes
on wealth accumulation, the timing of intergenerational transfers, and the volume and
timing of charitable giving. In so doing, we examine the findings with respect not only to
their implications for optimal tax policy, but also their implications for the key
macroeconomic controversies about the nature of intergenerational links and, by further
implication, fiscal policies. In the process, we highlight findings that may be inconsistent
with a unitary model of family and/or with forward-looking, dynamically consistent,
behavior.
The one important caveat to all that follows is that estate taxes (at least the federal
variety) are, and have always been, only for the rich. Over its history the U.S. estate tax
has applied to at most the richest 6 percent of decedents, and in recent years has applied
to a much lower percentage. This fact has two implications. First, generalizing any
insights gleaned from the population subject to the estate tax to the whole population may
be misleading. This will be especially true if behavior is not scalable. Second, because
the tax applies only to the rich, it may have important implications for the distribution of
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wealth, income, and well-being. For example, what to some observers is evidence of an
unfortunate negative impact on wealth accumulation may to others be seen as evidence of
a successful redistribution of wealth. This paper begins with a brief discussion of the
U.S. estate and gift tax law and the population it applies to, and then turns to a discussion
of its effects.

An Overview of Transfer Taxes

This section summarizes current law, presents the key features of the 2001 tax
legislation, and provides some characteristics about estate tax returns.1

Current Law

Federal law imposes an integrated set of taxes on estates, gifts, and generation-
skipping transfers.2 By law, the executor of an estate must file a federal estate tax return
within nine months of the death of a U.S. citizen or resident if the gross estate exceeds a
threshold that in 2002 is $1,000,000. The gross estate includes all of the decedents' assets,
his or her share of jointly owned assets, and life insurance proceeds from policies owned
by the decedent. The gross estate also includes all gifts made by the decedent in excess

1. For information on the history of the U.S. estate and gift taxes, see Appendix. See Joint Committee on
Taxation (1998) for a more detailed treatment of current law and the legislative history of transfer taxes.
Parts of this and the next section draw on Gale and Slemrod (2001).
2. States may also impose estate, inheritance, or gift taxes. The laws that govern how and to whom
property may pass are the exclusive domain of the states. For example, many states provide a surviving
spouse and minor children with some protection against disinheritance. In cases of intestacy, state laws
provide a structure to guide succession.
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of an annual exemption that in 2002 is $11,000 per recipient per year, and is indexed for
inflation. The estate may also include other property over which the decedent had
control, wealth transfers made during life that were either revocable or provided for less
than full consideration, and qualified terminable interest property (QTIP).3
Typically, assets are valued at fair market value. But closely-held businesses are
allowed to value real property assets, up to a maximum allowed value, at their "use
value" rather than their highest alternative market-oriented value. In addition, it is often
possible to discount asset value when such assets are not readily marketable or the
taxpayer's ownership does not correlate with control.4 The estate is usually valued as of
the date of death, but alternatively may be valued six months after the death, if the value
of the gross estate and the estate tax liability decline during this period.5
The estate tax provides unlimited deductions for transfers to a surviving spouse
and contributions to charitable organizations. Deductions are also allowed for debts
owed by the estate, funeral expenses, and administrative and legal fees associated with
the estate. In addition, interests in certain qualified family businesses were allowed an
extra deduction for the value of the business being transferred.
After determining the value of the net estate – gross estate less deductions – the
statutory tax rate is applied. In 2002, the lowest rate that any taxable return faces is 41
percent. The tax rate rises in several stages to 50 percent on taxable transfers above $3
million. Another credit is given for state inheritance and estate taxes (but not for state gift

3. Qualified terminable interest property (QTIP) is created when the estate of the first spouse to die receives
an estate tax deduction for a wealth transfer that provides the surviving spouse an income interest only and
provides the remainder interest to someone else. When the second spouse dies, the QTIP is included in
his/her estate.
4. See Richard Schmalbeck (2001).
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taxes).6 The credit rate is based on the "adjusted taxable estate," which is the federal
taxable estate less $60,000, and as of 2001 the allowable credit ranged from zero to 16
percent of the base; the 2001 tax law, though, phases out this credit until 2005, at which
time state estate and inheritance taxes become deductible from federal taxable estate.
Most states now levy so-called "soak-up" taxes that exactly mirror the credit limit, so that
the state transfer taxes shift revenue from the federal to the state treasuries without adding
to the total tax burden on the estate.
Tax payment is due within nine months of the decedent's death, although a six-
month filing extension may be obtained. However, the actual timing of the tax payment
can be flexible, as the law provides for ex post spreading out of tax payments over 14
years for closely-held family businesses. 7
To reduce tax avoidance under the estate tax, the federal gift tax imposes burdens
on transfers between living persons that exceed the annual gift exemption of $11,000.
Although the estate and gift taxes are said to be unified, the taxation of gifts and estates
involves some important distinctions. Gifts are taxed on a tax-exclusive basis, while
estates are taxed on a tax-inclusive basis. This provides a sizable tax advantage to giving

5. If the six-month alternative valuation date is used, assets that were liquidated in the interim are valued at
their sale price.
6. Additional credits are also allowed for gift taxes previously paid, and for estate taxes that were
previously paid on inherited wealth. The latter is phased out over ten years, in two-year intervals, from the
date the wealth was inherited, and is intended to reduce the extent of (double) taxation of recently inherited
wealth.
7. Moreover, in the presence of a well-functioning market for life insurance, a one-time estate tax liability
at an uncertain future date can be transformed into a series of annual premium payments. In this context, it
is interesting to note that the original estate tax law passed in 1916 contained a provision allowing for
prepayment of estate tax liability with a 5 percent discount per year. This provision was eliminated by the
Revenue Act of 1918.
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gifts rather than bequests.8 The taxation of inter vivos gifts also involves a disincentive to
giving. When an appreciated asset is transferred as part of an estate, the asset's basis is
"stepped up" (i.e., made equal to) to the market value at the time of death, thus exempting
from future income taxation the appreciation during the decedent's lifetime. In contrast,
if the asset is given inter-vivos, the donor's cost basis (often, but not always, the original
purchase price) is "carried over" as the asset's basis. In this case, if the recipient sells the
asset, capital gains that accrued before the gift was made would be taxed under the
income tax.
Federal law also imposes a tax on generation-skipping transfers (GSTs). Under
the estate and gift tax, a family that transferred resources over more than one generation
at a time (for example, from grandparent to grandchild) could in principle reduce the
number of times the wealth was subject to tax over a given period, and could greatly
reduce its transfer tax liabilities. To close this avoidance mechanism, generation-
skipping transfers in excess of $1 million per donor generate a separate tax, at rates up to
55 percent, above and beyond any applicable estate and gift tax. The GST tax raises
virtually no gross revenue, but does appear to successfully close the loophole noted
above.9

8. Formally, if the marginal estate tax rate is e, the effective marginal gift tax is e/(1+e). For example,
suppose the applicable estate tax rate is 50 percent and consider the implications of a giving a gift or a
bequest that costs the donor $15,000, including taxes. If the funds are given as an inter-vivos transfer, the
recipient would receive $10,000 and the donor would pay gift tax of $5,000 (50 percent of $10,000). If the
funds are given as a bequest, the recipient would receive only $7,500, and the estate would owe $7,500 in
taxes (50 percent of $15,000). Thus, in this example, the estate tax is 50 percent of the gross-of-tax
bequest; the gift tax is 50 percent of the net-of-tax gift but only 33 percent of gross-of-tax gift by the donor.
9. See Schmalbeck (2001). Writing from the practitioner’s perspective, Sherman (1992) claims that some
estate plans are designed to make use of the $1,000,000 tax exemption.
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The 2001 Tax Bill

George W. Bush campaigned on a pledge to eliminate the federal estate and gift
tax over a ten-year period. The bill eventually passed by Congress and signed by
President Bush did eliminate it, but only during the year 2010. Between 2002 and 2009,
it provides for gradual reductions in tax rates and increases in the effective exemption
level.10 For 2002, it repeals the 5-precent surtax designed to phase out the benefits of
graduated rates for large estates and increased the exemption amount to $1 million.
Between 2002 and 2009, it provides for gradual decreases in the top rate to 45 percent,
and increases in the exemption level to $3.5 million. Finally, the credit for state estate
and inheritance taxes is also phased out, by being reduced by 25 percent in 2002, by 50
percent in 2003, by 75 percent in 2004, and repealed in 2005 and thereafter, when there
will be a deduction paid for any state taxes.
The real excitement is scheduled to begin in 2010. The new tax law provides for
the repeal of estate and generation-skipping taxes in 2010. Also in 2010, the top gift tax
rate becomes the top individual income tax rate of that year; this was designed to
eliminate income tax avoidance opportunities opened up by the repeal of the estate tax
itself.
Repeal in 2010 is followed by reinstatement in 2011. As with all of the
provisions of the 2001 tax law, the estate and gift tax provisions do not apply to 2011 and
after, thus reinstating the tax law prior to the 2001 law. Thus, if the law were to unfold as

10. Under prior law the exemption level was already scheduled to gradually increase to $1 million by 2006.
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legislated, the estate tax would have a top rate of 45 percent in 2009, disappear in 2010,
and return with a top rate of 55 percent in 2011 and after.

Characteristics of Estate Tax Returns

Besides shedding light on fundamental behavior patterns of families, the estate tax
also serves a more prosaic role – it generates much interesting data. Evidence on the
gross estate, deductions, and tax payments from estate tax returns filed can help shed
light on several issues. Note, though, that most of the published data about estate tax
returns does not distinguish between returns with a surviving spouse, and those without a
surviving spouse. In the macroeconomics literature, though, the term “bequests” usually
refers to an intergenerational transfer, and only rarely is it noted that most often it is a
married couple making decisions about estate planning.11
In 1998, roughly 98,000 estate tax returns were filed, amounting to 4.3 percent of
adult (age 20 or higher) deaths in the United States in 1997.12 Total gross estate among
1998 returns equaled $173 billion, or less than 0.5 percent of privately held net worth.13
The size distribution of gross estates is highly skewed. The 89 percent of returns
with gross estate below $2.5 million accounted for 53 percent of total gross estates. The
4.1 percent of estates valued in excess of $5 million accounted for 32 percent of gross
estate value. Taxable returns, i.e., returns that paid positive taxes, accounted for 49
percent of all returns and 59 percent of total gross estates.

11. Michael Hurd (1994) is an exception.
12. Hoyert, Kochanek and Murphy (1999).
13. Federal Reserve Board (2000).
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Personal residence and other real estate accounts for about 19 percent of gross
estates, stocks (other than closely held), bonds and cash account for 61 percent, and small
businesses (closely held stock, limited partnerships, and other non-corporate business
assets) account for 8 percent. Farm assets account for 0.5 percent of all gross assets in
taxable estates.14
Deductions account for 41 percent of gross estate on average, but this ratio varies
dramatically with estate size. For estates with gross assets below $1 million, deductions
accounted for 25 percent of gross estate. For estates above $20 million, deductions were
56 percent of gross estate. The composition of deductions also changes with estate size.
Bequests to surviving spouses account for between 60 and 75 percent of all deductions in
each estate size category. In contrast, charitable contributions represent 11 percent of
deductions for estates below $1 million, but rise to 27 percent of deductions for estates
above $20 million.
Because differences in deductions relative to gross assets are the main reason why
some estates are taxable and some are not, it is not surprising that deduction patterns vary
by taxable status. Among taxable returns, overall deductions, spousal deductions and
charitable contributions all rise as a share of estate as estate size rises. For nontaxable
returns, deductions are much higher as a proportion of estate size, and in particular
bequests to a surviving spouse are substantial. Martha Eller, Barry Johnson and Jakob
Mikow provide extensive additional data on features of decedents and asset and
deduction patterns in estate tax returns.15

14. This figure excludes farm real estate, which accounted for 2.6 percent of gross estates. The remaining
amount of gross estates is in insurance, annuities, and other assets. We thank Barry Johnson for providing
this information.
15. Eller, Johnson and Mikow (2001).
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The Impact of the Estate Tax on Wealth Accumulation and Avoidance

The estate tax increases the price of bequests relative to lifetime consumption. In
the simplest model, an individual decides how to allocate resources (we denote them by
W) between consumption (C) and a bequest (B). Both of these choices yield utility, as
represented by the utility function u(C,B). The individual is subject to a budget constraint
that can be expressed as C+X=W, where X is the total estate. The estate finances both a
bequest and the estate tax T(.), so that it is equal to X=B+T(X). This last identity defines
the estate as a function of the bequest X(B), and using the implicit value theorem yields
X'(B)=(1-T')-1, i.e., an increase of bequest by one dollar requires increasing the estate by
(1-T')-1 dollars. Setting the price of consumption to be one, the relative price of bequests
to consumption is therefore (1-T')-1, so that high marginal estate tax rates increase the
relative price of bequests. This tradeoff is intuitive and well understood, although it
should be pointed out that due to the interaction of income and substitution effects, the
theory cannot unambiguously predict whether an increase in estate tax rates would
increase or decrease the size of the estate.16
An enormous body of work attempts to measure the impact of various aspects of
the tax system on various aspects of behavior. Some of it is relevant to the question of

16. Note also that the presence of various means of avoiding the estate tax does not affect this relative
price. On the margin, any avoidance activity will be performed to the point where its benefit (saving on the
estate tax) is equal to its cost (consisting of direct administrative and tax planning costs, possible loss of
control over assets, and other distortions). Therefore, as long as the estate tax is paid, the marginal tax rate
is the marginal price one should concentrate on, just as the marginal income tax rate is the focus of
attention in the modern analysis of income tax distortions (Feldstein 1995). Slemrod (2001) qualifies this
statement. Applying his argument in this context, if marginal wealth accumulation reduces the marginal
cost of a dollar of avoidance, the effective tax on wealth accumulation is less than the statutory rate.
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